Months ago, I (really Steve Waldman of Interfluidity) proposed a possible reason people were freaking out over inflation: The returns to cash after accounting for BOTH short term interest rates and inflation were negative for the first time in 30 years. We were seeing actual debasement for holders of cash.
However, there is another reason to be worried about inflation. Holders of existing assets would get wiped out if inflation were to rise to 5%., because discount rates on assets would cause asset values to tumble.
Assets are valued by using a discount rate. The simplest way to value an asset is to assume it has infinite life, and then divide the cash flows generated by some discount rate. If we use $100 for the cash flows, and then assume the discount rate is 3%, the value spit out by this equation is $3,333.33.
This is essentially the model the fed uses to figure out a *fair* value for the stock market. The fed model was to take the 10 year rate, and divide Earnings yield by the 10 year to get a value.
If inflation were to go up to say 5% per year, it’s entirely possible the 10 year yield would go up to 7%. What would this do to equity values? The value of that same $100 is only 1,428.57 using .07 as the divisor.
Assets would fall in value about 60% if inflation was to actually hit 5%. I can see why many people would be very worried about inflation, given that nearly every asset in the U.S. would fall in value by 60%.
Can you imagine what would happen to our housing market and economy if we saw inflation hit 5%?